In this article, we explain in simple terms what a mutual fund stress test is and what investors need to appreciate while investing in mutual funds, especially small cap mutual funds.
If you have not seen the movie Margin Call, I strongly suggest you do so after reading this article. You could appreciate the situation better if you have already seen it. Demand vs supply forces determine the price of a stock, bond, or commodity in the market.
If buyers exceed sellers, then the price moves up and vice versa. An excellent book to appreciate these dynamics is Bulls, Bears and Other Beasts: A Story of the Indian Stock Market.
What happens during a market crash? Everyone wants to get out, so sellers far exceed buyers. And the sellers are happy to pay any low price that the buyer demands to get out. The more the sellers, the more the price gets driven down.
In a mutual fund, market crashes result in a risk that very few people seem to acknowledge – redemption pressure. As more and more unit holders want to exit the fund, the fund manager will have to sell more and more securities at a lower and lower price. So, the NAV could take a larger hit than representative broad market indices.
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This happened in March 2020 when Franklin closed six debt funds because the underlying bonds could not be sold in the open market. While investors focused on what Franklin Templeton Indian did or did not do or should have done, the underlying risk – redemption pressure or liquidity risk got sidelined.
The same situation can also occur in any equity fund, not just small cap funds, just that the risk is highest in small cap, the mid caps come next and then the large caps. This liquidity risk can evaluated with a metric known as the impact cost.
If I want to buy/sell one stock, there could be a small, even negligible, difference between the buying price and selling quoted. As the number of stocks I want to buy/sell increases, the price difference also increases. The impact cost measures this.
What is impact cost?
The following example has been derived from the NSEs impact cost definition page. Suppose the stock exchange order book looks like this at some instant.
| Quantity | Buy Price | Sell Price |
| 1000 | 100 | 102 |
| 2000 | 99 | 103 |
| 1500 | 96 | 104 |
The quantity of shares for buying and selling will differ, but we have assumed it to be the same to keep things simple. Suppose I want to buy 2000 shares. Ideally, I should be able to sell all of them at the selling price of Rs. 102. Since the buying price is Rs. 100, the bid-ask spread is only Rs 2. So, we first define the ideal buying price as (102+100)/2 = 101
However, I can only buy 1000 shares in one lot at Rs. 102. The second lot of 1000 shares will be purchased at Rs. 103 (assume instant buys). So the average buying price for this trade is:
[(1000 x102) + (1000 x 103)]/2000 = 102.5
This Rs. 102.5 is 1.5% higher than the ideal buying price of Rs. 101. This 1.5% is known as the impact cost (for buying).
Impact cost is dynamic and depends on the quantity of shares involved in the transaction. There is a separate impact cost of buying and selling. The exchange can impose a penalty if the stock is not liquid enough, resulting in a higher cost.
The impact cost for selling will increase with a decrease in market capitalization. This is the proper way to differentiate large, mid, and small cap stocks. This is an analysis done in 2019. Things have likely improved now, but don’t set the expectations too high – Warning! Even “large cap” stocks are not liquid enough! Can you handle this?
So when the market falls, and investors want to pull out the funds, all funds will suffer to different extents just that it would be easier for a large cap fund manager to handle redemptions (sell stocks and turn them into cash for disbursal) than a small cap fund manager.
So, what do these stress tests tell us? Not much. We will only know how much the NAV will fall when the market falls. Simulations cannot replicate real stress on volume and liquidity. How long it would take theoretically or even practically for a fund manager to sell 25% or 50% of assets is of little use to investors.
During the market crash, they will turn from “long term” investors to “I want my money back” faster than the flip of a switch. The real stress test is education about risk and expectations. Otherwise, experience will teach us some hard lessons. It is immature to assume one can compensate for a low income by seeking a higher return. See: Is there any proof small cap mutual funds would outperform in the long term?
Regular readers may know that freefincal has always opposed investing in small cap mutual funds. Due to their highly volatile nature, returns can quickly swing from spectacular to disastrous and are most impacted by sideways market movements.
Investing in a flexicap fund with a “small” exposure to these funds is a relatively better idea. If you “must” invest in a small cap fund, then have only a small exposure and whenever you feel the gains are spectacular, redeem some amount and shift to equity or fixed income as per your asset allocation.
These are some of our earlier work on small cap funds:
- Why are you not recommending mid cap and small cap funds?
- Will my gains reduce if I invest more in my small cap mutual fund?
- Which small cap mutual fund should I include in my portfolio?
- Why investing in small cap mutual funds does not make sense!
So, if you are already invested in small cap funds and are wondering what to do, here are our suggestions: Is it time to exit small cap mutual funds? (Article dated March 5th 2024).
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